We’ve all heard that Maroon 5 song line “it’s not always rainbows and butterflies”. We definitely wish life were just a walk in the park, but there ain’t no better teacher than challenges and experiences, right?
Like the wonderful mess than is our life, businesses have their upsown and downs, too. Businesses and the economy undergo several phases as they go along. These phases are, commonly referred to as, the “business cycle”. And as investors, it is important to understand what these stages are to help guide your investment decisions.
There are four major phases in a business cycle. The economic phases have huge implications for business valuation, economic factors and company market prices. As the business cycle moves through its phases, it is essential for investors to re-assess their current portfolio (a term for a collection or group of investments) in order to take advantage of the opportunities brought about by the next phase.
How do you do that? Simple. By investing in sectors that are performing well and avoiding those that don’t.
Alright, so imagine you just got off a nasty breakup with someone you’ve been with for the longest time. It’s painful, right? But then, it finally occurs to you that sticks and stones won’t break your bones. Alas! It’s in that moment that you start to move on.
Recovery is to the business cycle as moving on is to relationships. This is when the business starts to slowly recover from the pains brought about by recession (which we’ll discuss shortly).
As a response to recession, the government is likely to undertake measures to make sure the economy recovers. It is in the recovery stage that these government efforts start to show visible and promising results. Consumer expectations start to rise, industrial production grows and interest rates lower. In this stage, the economy starts to expand and stabilize. After a while, economic growth starts to materialize, rise and strengthen.
Performing sectors: Interest-rate sensitive sectors such as Consumer Discretionary and Financials historically have outperformed the market. Due to low interest rates, people start to increase borrowing (Financials) and increase spending on items on non-essential goods (Consumer Discretionary). The shift from recession to recovery also boosts the Technology and Industrial sectors. Overall, increased production also causes the Materials sector to outperform.
So let’s go back a little bit to the break-up. You’ve moved on and things start to get colorful again. You start to realize you’re stronger now. To celebrate your “rebirth” and new-found freedom, you engage yourself in a lot of things like yoga, painting, further studies, travel – you know, those things that actually make you a better person. These activities expand your horizons and then, you finally start dating again! You meet this wonderful person who is so unlike your ex and things start to flourish between you two. Awww.
This is the expansion phase. Expansion is the continuation of recovery and in this phase, the progress gained from recovery gains momentum. As a result of this economic expansion, overall investor confidence strengthens.
Along with the economic growth, individual businesses would also want to expand. To make this possible, they engage in short-term borrowings which may push interest rates higher since banks and financial institutions would want to take advantage of this demand for cash (for further reading check out: Why do interest rates rise and fall?). Commodity prices also go up since companies would want to replenish their inventories to keep the business rolling. The economy grows rapidly until it reaches its peak.
The expansion phase typically is the longest phase in the cycle. We hope we could say the same in relationships!
Performing sectors: Historically, the Technology sector has been the best performer during a mid-cycle phase. Due to a growing economy, sector leadership rotate rapidly since sectors oftentimes outperform each other in short periods of time. Furthermore, Consumer Staples and the Energy sector most commonly perform well in the expansion phase.
So you’ve been dating this person for quite a while now and you start to notice the things that really bother you. Maybe it’s them being notoriously late all the time, being irresponsible, having a lack of ambition, procrastination, hygiene or attitude towards your closest friends – it makes you start to wonder if this relationship will work out. Then you two start fighting all the time over the most inconsequential things. You feel that your relationship is declining.
This scenario may be compared to the late-cycle or decline phase. When the economy reaches its peak, there’s nowhere to go but down. Interest rates start to rise rapidly and prices of goods and services increase on a relatively faster rate. The overall growth of money supply becomes lower due to decreased spending.
Performing sectors: As economic recovery starts to mature, the Energy sector and Material prices have generally done well due continued production and demand. Sectors which consumers could not do without such as Consumer Staples and Utilities perform well during the decline phase. People also tend to be more concerned with defensive options considering the economy is peaking so the Health Care sector also tends to perform well.
You can’t take it anymore. The relationship is just too toxic for you to handle. You finally decide to dump the person you’ve been dating and it just hurts so bad! You seldom eat, leave the house or do anything for yourself. You start to miss your ex and you end up feeling depressed. You think it’s all downhill from there… but you’ve never been more wrong.
This sounds a tad too dramatic but recession is the equivalent of breakup in the business cycle parlance. The early sign of recession is when the economy starts to slow down. In this phase, unemployment rates increase, interest rates go through the roof, overall income declines, bankruptcy rates rise, and the economy weakens.
Performing sectors: Sectors carrying the essentials such as Consumer Staples and Utilities outperform the other sectors during a recession. Health Care and Telecommunications have also historically done well during this phase.